Predicting corporate financial distress based on integration of decision tree classification and logistic regression

Abstract

Lately, stock and derivative securities markets continuously and rapidly evolve in the world. As quick market developments, enterprise operating status will be disclosed periodically on financial statement. Unfortunately, if executives of firms intentionally dress financial statements up, it will not be observed any financial distress possibility in the short or long run. Recently, there were occurred many financial crises in the international marketing, such as Enron, Kmart, Global Crossing, WorldCom and Lehman Brothers events. How these financial events affect world’s business, especially for the financial service industry or investors has been public’s concern. To improve the accuracy of the financial distress prediction model, this paper referred to the operating rules of the Taiwan Stock Exchange Corporation (TSEC) and collected 100 listed companies as the initial samples. Moreover, the empirical experiment with a total of 37 ratios which composed of financial and other non-financial ratios and used principle component analysis (PCA) to extract suitable variables. The decision tree (DT) classification methods (C5.0, CART, and CHAID) and logistic regression (LR) techniques were used to implement the financial distress prediction model. Finally, the experiments acquired a satisfying result, which testifies for the possibility and validity of our proposed methods for the financial distress prediction of listed companies. This paper makes four critical contributions: (1) the more PCA we used, the less accuracy we obtained by the DT classification approach. However, the LR approach has no significant impact with PCA; (2) the closer we get to the actual occurrence of financial distress, the higher the accuracy we obtain in DT classification approach, with an 97.01% correct percentage for 2 seasons prior to the occurrence of financial distress; (3) our empirical results show that PCA increases the error of classifying companies that are in a financial crisis as normal companies; and (4) the DT classification approach obtains better prediction accuracy than the LR approach in short run (less one year). On the contrary, the LR approach gets better prediction accuracy in long run (above one and half year). Therefore, this paper proposes that the artificial intelligent (AI) approach could be a more suitable methodology than traditional statistics for predicting the potential financial distress of a company in short run.